The Breakdown - Will Earnings Reports Portend Recession?

Episode Date: October 12, 2022

This episode is sponsored by Nexo.io, Circle and FTX US.   On today’s episode, NLW checks in on the macro scene, including: What the earnings report season that begins this week might tell us about where corporate America is headed Why the Federal Reserve still doesn’t care about stock prices  Why the former whales in the market aren’t buying Treasurys like they used to    - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “The Now” by Aaron Sprinkle and “The Life We Had” by Moments. Image credit: lemono/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexo.io, Circle, and FtX, and produced and distributed by CoinDesk. What's going on, guys? It is Tuesday, October 11th, and today we are catching up on the big stories dominating macro analysis. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always.

In addition to them being a sponsor of the show, I also work with FTX. So like I said, today we are going to go a little deeper on some of the big stories shaping markets and macroeconomic analysis. And for the sake of full transparency, I'm actually recording this on Monday afternoon. We have to go get a last-minute passport for one of our littles tomorrow. and so I wanted to make sure that the show wasn't late. But given the world as it is now, I always want to tell you guys if I'm recording in advance

in case something crazy happens that I just don't cover and don't explain why. So as mentioned yesterday, there is a new earnings period coming up and things aren't looking great. TLDR, investment analysts are thinking that what we get for last quarter won't be terrible, but the indicators of what to come will likely be much worse.

And in fact, to some extent, what investors are going to be looking at isn't so much the last three months of performance, but instead how public company executives view the possibility of future growth. As Bloomberg put it, on that, the news will probably be bad. To give a sense of how earnings expectations have changed over the past six weeks or so, companies ranging from FedEx to Ford to Nike to Nvidia and many more have either reduced their forecasts or have tried to tamp down expectations. In many of these cases, this tamping down of expectations has led to more than a 10% decline in stock price. Bank of America thinks it's just

going to get worse. In a note, they wrote, guidance is going to be terrible. We expect guidance to weaken even further going forward and more downward revisions across the board. Morgan Stanley discussed the, quote, double whammy of inventory oversupply amid slowing demand. Going on, they write, things like inventory, labor costs, and other latent expenses are wreaking havoc on cash flow. The market has started to see cracks with some bellwether stocks reporting both top line and bottom line misses in recent weeks. Other analysts are focused on the strength of the dollar. The dollar is currently on track for a six-strait quarterly value increase, which is a huge problem for companies with big overseas revenue. Goldman pointed out that if the dollar

continues to strengthen, it would, quote, support the performance of stocks with 100% domestic sales relative to those with a higher portion of foreign sales. This has also been validated in numbers, where a Goldman basket of stocks that has 100% of their revenue coming from the U.S. has outperformed another basket that gets 71% of revenue from foreign sales. Adding to these headwinds is the Inflation Reduction Act, which imposes a 15% minimum tax on corporate book income and a 1% excise tax on buyback starting next year. Add all this up, and it's not exactly surprising why the S&P 500 started down 0.7% on Monday following a 2.8% decline on Friday. More than 60% of the respondents to a recent sentiment survey said that this earning season will push the S&P 500 even lower.

underscoring this comments from J.P. Morgan Chase Chief Jamie Diamond got a ton of play. Quote, these are very, very serious things which I think are likely to push the U.S. and the world, I mean, Europe is already in recession, and they're likely to put the U.S. in some kind of recession six to nine months from now. Diamond speculated, like many on FinTwit, that the cracks will show first in the financial sector. Quote, the likely place you're going to see more of a crack and maybe a little bit more of a panic is in credit markets, and it might be ETFs, it might be a country, it might be something you don't expect. If you make a list of all the prior crises, sitting here we would not have

predicted where they came from, although I think you could predict this time that it will probably happen. So if I was out there, I'd be very cautious. In total, Diamond thinks that the S&P 500, which is already down almost 25% this year, could go down another 20%. What's more, the next 20%, he said, will be more painful than the first. Honestly, to get a sense of the vibe out there, look no farther than a piece in the Wall Street Journal a couple of days ago titled, How to Make Peace with your stock market losses. Alas, as listeners here well know, the Fed has given no indication that it cares at all about stock market prices declining. Fed Vice-Chairwoman Lail Braynard spoke on Monday and basically reinforced what we've been hearing this whole time. Quote, monetary policy

will be restricted for some time to ensure that inflation moves back. It will take time for the cumulative effect of tighter monetary policy to work through the economy and to bring inflation down. The moderation and demand due to monetary policy tightening is only partly realized so far. In light of elevated global economic and financial uncertainty, moving forward deliberately, and in a data-dependent manner, will enable us to learn how economic activity, employment, and inflation are adjusting to cumulative tightening in order to inform our assessments of the path of the policy rate. Summary headlines included Fed's brainard, a really important risk that inflation expectations could start to drift, which would make the Fed's job harder.

Easing prematurely as a risk, but at some point risks could become more. or two-sided. Now, Adam Cochran quote tweeted and said, Braynard is by far the most doveish of the Fed members, and her statements are at best on the hawkish side of neutral, but not everyone agreed. Claudia Assam, who is an economist who has been outspoken about the Fed needing to not be so callous about having to cause a recession to end inflation, drew some optimism from the speech. First, she pointed to Braynard's speech as an example of the Fed understanding the global implications and interplays, particularly of a strong dollar. She points to an excerpt from Braynard,

monetary policy tightening is also proceeding rapidly abroad. Many central banks and large economies have raised rates by 125 basis points or more in the past six months, and yields on 10-year sovereign debt in Canada, the United Kingdom, and the largest euro area economies have seen increases on the order of 190 to 360 basis points this year. The combined effect of concurrent global tightening is larger than the sum of its parts. The Federal Reserve takes into account the spillovers of higher interest rates, a stronger dollar, and weaker demand from foreign economies into the United States, as well as in the reverse direction. We are attentive to the risk of further adverse shocks, for instance, from Russia's war against Ukraine, the pandemic, or China's

zero-COVID policies. We are also very aware that the cross-border effects of unexpected movements and interest rates and exchange rates, as well as worsening external imbalances in some cases could interact with financial vulnerabilities. In this environment, a sharp decrease in risk sentiment or other risk events that may be difficult to anticipate could be amplified, especially given fragile liquidity in core financial markets. In some countries, the realization of these risks could pose challenging tradeoffs for policy. Claudia also points to a part in Braynard's speech that Andrew Elrond argued is being underreported and has been before as well.

This is a focus on another dimension of where improvements in inflation could come from, which is companies lowering their prices. Elrond and Somm actually tweeted the same section of the speech, with Elrod adding, underreported in Brainer's remarks for at least the second month in a row, is attention to profit margins which for retailers remain more than double the bump in wages, and for car dealers are more than 10x. The excerpt in question reads, since the pandemic, significant supply and demand imbalances have coincided with large increases in retail trade margins in several sectors. In some sectors,

the increase in the retail trade margin exceeds the contemporaneous increase in wages paid to the workers engaged in the retail trade, although this is not true in food and apparel. The return of retail margins to more normal levels could meaningfully help reduce inflationary pressures in some consumer goods, considering that gross retail margins are about 30% of total sales dollars overall. For instance, among general merchandise retailers, where the real inventory to sales ratio is 20% above its pre-pendemic level, retail margins have increased 20% since the onset of the pandemic, roughly double the 9% increase in average hourly earnings by employees in that sector. In the auto sector, where the real inventory to sales ratio is 20% below its pre-pendemic level,

The retail margin for motor vehicles sold at dealerships has increased by more than 180% since February 2020, 10 times the rise in average hourly earnings within that sector. So there is ample room for margin recompression to help reduce goods inflation as demand cools, supply constraints, ease, and inventories increase. Now, the corporates are charging too much explanation and political narrative around inflation was not very successful for the Biden administration and so hasn't really been pursued. But it's interesting to see that it's making a little peak here, at least in this speech from a Fed official. Importantly, Claudia also pointed to another Fed speaker, Charlie Evans, the Fed president of the Reserve Bank of Chicago, as sounding a comparatively doveish tone in his remarks on

Monday as well. She writes, so far Evans is the most dovish speech I've heard in a long time. Even so, that's a relative statement to his peers. Evans not freaking out over inflation expectations and sees them as anchor now, and that will help bring inflation back down to target. He also said, overshooting on federal funds rate is costly, too. Claudia concludes her thread, big problem now is that the Fed, including him, is not talking about the global feedback effects from the Fed's aggressive tightening to the strong dollar to the global recession and to then US recession. Juliettec intimated something similar last week, tweeting, like it or not, it's soft landing in the U.S. and it's becoming the largest macro issue I ever encountered. The chickens

are coming home to roost for the U.S.D as a reserve currency problem. Raul Paul responded, what do you mean? And she says U.S. is soft landing. Rest of the world is hard landing, largely in part because of the U.S. soft landing, virtuous in the U.S., vicious in the rest of the world. It will be a long macro winter. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on NXO Pro. The new Spot and Futures trading platform uses aggregated liquidity

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Now, speaking of the relationship between the U.S. and the rest of the world, another piece from Bloomberg recently was titled, The Most Powerful Buyers and Treasuries are all bailing at once. Subheader, everywhere you turn, the biggest players in the $23.7 trillion U.S. Treasury's market are in retreat. The piece looks at Japanese pensions, life insurers, foreign governments, U.S. commercial banks, and of course the Fed itself, who is in the midst of balance sheet runoffs. The piece in Bloomberg says if one or two of these usually steadfast sources of demand were bailing,

the impact, while noticeable, would likely be little cause for alarm. But for every one of them, all at once, to pull back is an undeniable source of concern, especially coming on the heels of the unprecedented volatility, deteriorating liquidity, and weak auctions of recent months. Glenn Capello, who's got three decades as a Wall Street bond trader, said, we need to find a new marginal buyer of treasuries as central banks and banks overall are exiting stage left. It's still not clear yet who that will be, but we do know they're going to be a whole lot more price sensitive. While Bloomberg makes the point that people have predicted treasury market chaos in the past only for new buyers to step in,

it also recognizes that this time is different because of inflation. Credit Suisse's Zoltan Pozar talked about this in a recent live episode of Odd Lots. Since the year 2000, he said, there has always been a big central bank on the margin buying a lot of treasuries. Now, we're basically expecting the private sector to step in instead of the public sector, in a period where inflation is as uncertain as it has ever been. We're asking the private sector to take down all these treasuries that we are going to push back into the system, without a glitch and without a massive premium. Peter Bachfar, the chief investment officer at Blatley Financial Group, said it's dangerous to assume that there is a new natural buyer, in fact saying it's dangerous to assume that

treasuries will, quote, ultimately find buyers to take the place of the Fed, foreigners, and banks. So why are these sources of demand leaving? For Tokyo's pension and life insurance companies, the hedging costs are effectively too steep. Yields on U.S. 10-year notes are now in negative territory. Those hedging costs have surged because of the increase of the dollar, which is up more than 25% this year versus the yen. When it comes to commercial banks in the U.S., J.P. Morgan says the drop in bank demand has been stunning. As deposit growth has slowed sharply, this has reduced bank demand for treasuries, particularly as the duration of their assets has extended sharply this year. Putting some numbers on this in Q2 of 2022, banks purchased fewer treasuries since any quarter since the end of 2020.

Emerging markets are also down $300 billion in treasury buying this year, which is a significant decrease in demand from a group that usually puts about 60% of their reserves straight into U.S. dollars. So is there anyone jumping in? The answer is yes. Households, which is a catch-all group that also includes hedge funds, and basically all these folks who are coming out to crypto to find yield over the last couple years, now just have it waiting for them. Greg Ferreinello, the head of U.S. rates trading and strategy at Amerivet Securities, writes, the market is still trying to evolve and figure out who these new end buyers are going to be. Ultimately, I think it's going to be domestic accounts because interest rates are moving to a point where they're going to be very attractive.

Finally, one of the discussions that's coming increasingly into focus is whether the standard rate of inflation will be able to stay at its historic 2% level. Crypto liquidity provider Cumberland wrote a threat about this called the end of 2% inflation and what it means for crypto. Quote, this past weekend, the economist published an article called the end of 2%, a reminder that the inflation target set by central banks around the world is arbitrary and anything but guaranteed to last. The author subsequently speculates that by revising the target upward to 4%, central bankers can simultaneously engineer both a budgetary windfall and an off-ramp

into the impeding disinflationary purge slash crisis, etc. In the face of daunting, at best, or even insurmountable supply-side challenges, expecting a higher inflation target now seems like a rational base case. If this policy change is implemented, tacitly or otherwise, it would be a watershed moment for Bitcoin. The reason why is rooted in two tradeoffs. One, loss of faith. Hiking inflation targets is a slippery slope. It's also just another form of QE. Two, rising inequality. Assets and opportunities that insulate against the ravages of inflation are unavailable to most people. Tradeoff number one was cited in the original Bitcoin white paper and is philosophically at least its reason to be. Tradeoff number two isn't sustainable forever, but it can certainly

last for decades. During these regimes, capital tends to flow into assets that appreciate. Until crypto, assets were either hard, i.e. real, or financial. But now they can be digital, too. And unlike all other assets, the digital variety is universally accessible by design. This is historic. Some would argue that crypto has been a poor inflation hedge during this particular bear market. While true so far, it's important to remember that crypto is a debasement hedge, not an inflation hedge. In other words, Bitcoin won't protect a portfolio from a few hot CPI prints, but sustained, tolerated inflation is just another form of fiat currency debasement, a backdrop against which crypto performs spectacular. Ultimately, it seems unlikely that both monetary policy makers and elected lawmakers will join

forces to unleash both the Volkarian Firestorm and the fiscal austerity it would actually take to bring inflation under 2%. Thus, unless we're dealt to deflationary tech miracle, cold fusion, a higher inflation target or a bankruptcy cycle are the only ways out of this situation. If our central banks choose the former, a crypto summer is around the corner. If they choose the latter, look out below. It's somewhat surprising to me, actually, that we're just now starting to get this conversation. It feels inevitable that this target gets raised up, if for no other reason than debt servicing, and the concern that if it doesn't, governments around the world won't actually be able to pay back their debts.

Anyways, guys, that is the view of how this week looks from a macro perspective. For now, I want to say thanks again to my sponsors, nexo.io, circle and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. I want to tell you about CoinDesk's new event, the investing in digital enterprises and Asset Summit or Ideas. The event facilitates capital flow and market growth by connecting the digital economy with traditional finance. Join CoinDesk October 18th and 19th in New York City for a 360-degree

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